In November of 2010, renowned deep value investor Arnold van den Berg wrote a great piece called How do great companies get so cheap? He pointed out in the article that the stocks of the great companies like Wal-Mart (WMT), ADP (ADP) and Microsoft (MSFT) were on sale. He argued that the four emotions that investors went through when owning the stocks made them cheap: apathy, disgust, fear and anger. At the time of the writing, the stocks were traded at $54 (WMT), $43 (ADP), and $26 (MSFT). Since then their stock prices had gained 44%, 63%, and 34%, respectively.

The question we would like to ask now is: are these stocks still cheap?

To see if these stocks are cheap, we would like to check their valuations with three evaluation methods: DCF Calculation, Reverse DCF Calculation, and Peter Lynch Chart. Since all these three companies have quite stable and predictable business, DCF and Reverse DCF will work pretty well.

Wal-Mart has been growing its revenue by about 3.5% a year over the past 5 years. Its earnings grew faster, at about 5% a year, due to margin expansions. Coupled with about 4% a year of share buybacks, this giant company has been growing its earnings per share at the rate of 10% a year. Considering Wal-Mart has a very stable business, we may ask for lower discount rate in DCF and Reverse DCF Calculation. At 10% of discount rate, Wal-Mart is worth about $88 a share, which gives a margin of safety of 15% at the current market price. Please see the screenshot of the DCF Calculator below:

If we switch the DCF Calculator to Reverse DCF mode, it gives a growth rate of 7.8% as shown below:

Over the past 10-year and 5-year periods, Wal-Mart has grown its revenue and earnings per share slightly faster than that. Based on the calculation, we can confidently see that Wal-Mart is probably slightly undervalued or fair valued.

This is further confirmed by the Peter Lynch Chart of Wal-Mart below:

Historically Wal-Mart was traded at much higher valuations. Please see the historical P/E chart below:

Currently Wal-Mart is traded at the P/E ration of 15.1. The lowest point was below 12 at about two years ago.

Microsoft has been perceived as a company that has had its days. Indeed, its growth rate has slowed down dramatically over the past 5 years. But the company has very strong cash flow, which allows it to buy back shares while still growing its sales. The 5-year average earnings per share growth rate is about 6.6%, which is the rate we use for DCF Calculation. Because Microsoft carries tremendous amount of excess cash, we added its tangible book value to its DCF calculation. The DCF screen shot is below:

The DCF Calculation gives a fair value of $32, which is 7% below its current price. The Reverse DCF suggests that the company needs to grow its eps at 7.8% a year, which is slightly higher than its growth rate over the past 5 years. This may suggest that Microsoft is slightly overvalued.

This is the Peter Lynch Chart of Microsoft:

The Price Line and the Earnings Line are close to each other, again suggesting fair value for Microsoft.

ADP is the slowest grower among all these three companies. The historical low interest rate hurt its growth and margins. The company grew its revenue at about 5% a year over the past 5-years, while its margin shrank and its profit declined. Even with share buyback, the company only grew its earnings at about 3% a year. Assuming 6% growth, 10% discount rate for DCF Calculation, the stock still appears to be overvalued. This is also confirmed by the Peter Lynch Chart:

Historically ADP has been traded at a higher P/E. The historical median P/E ratio is 23.6, which is exactly where it was traded at. ADP price and its Earnings Line of historical median P/E of 23 is shown below:

Therefore, ADP stock is probably somewhere between fair-valued to overvalued.

Conclusion:

With the recent stock market run up, many large cap stocks that were out of favor are not undervalued any more. Among all the three companies discussed here, none of them is clearly undervalued. If one has to invest one of them, Wal-Mart would be the best choice, although most likely it will not deliver as large gains in the coming years as it did in the last two years.

As suggested by GuruFocus market valuation page, the US market is overvalued, and it is positioned by the annual gain of 2-3% a year in the coming years. We do not know where the stock market will go, but as value investors, the bottom up approach clearly indicates that bargains are much harder to come by these days.

Comments

Thank you for the article. Aren't you calculating the earnings per share of Microsoft with a flawed measure given that 2012 EPS has an non recurring write off of more than 6 billion? EPS without that write off would be near 2.70.

Also, if you don't account for this one time charge off, your growth rate is also negatively affected; excluding the one-time charge, the growth rate in the last 5 years should be around 7.5%.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.